Markets & Finance

Strong Growth for a Loan Leader


By Erik J. Eisenstein This week's S&P Focus Stock of the Week is Countywide Credit Industries (CCR), which carries S&P's highest investment ranking of 5 STARS (buy). Countrywide is the nation's largest independent mortgage banker, third largest originator and fourth largest servicer of mortgages, funding prime, sub-prime and home-equity loans through consumers, brokers and correspondent financial institutions. CCR is also the leading online mortgage originator. In addition to mortgage funding, Countrywide offers loan closing services, mortgage-related investment banking and insurance.

In anticipation of the Federal Reserve easing cycle, mortgage rates dropped at the end of 2000, and have remained around 7% thus far in 2001, fueling a banner year for home lending. Standard & Poor's projects 50% growth in mortgage originations, to $1.5 trillion in 2001, fueled by fixed-rate refinancings. While the peak of the boom probably occurred in the spring, it has continued with surprising strength. With the overall economy giving mixed growth signals, the market anticipates additional Fed rate cuts, keeping mortgage rates low. Moreover consumers are increasing taking advantage of low rates and built-up home equity not only to pare mortgage payments but other consumer debt. On July 25, the Mortgage Bankers Association reported a second sequential weekly increase in its Mortgage Loan Application Index, a leading indicator of home purchases and refinances, to a level 56% higher than a year ago.

Not surprisingly, leading mortgage banker Countrywide, with 6.8% of the total origination market, has reaped the benefits of this excellent operating environment by producing and selling fixed rate loans. Loan production revenue (67% of total revenues) surged 110% in the May quarter, year to year, driving EPS to $1.00, up from $0.72. Subsequently, CCR reported a record June for originations, applications and pipeline and reaffirmed its guidance for the August quarter.

Countrywide's performance however, is a testament to its technological leadership as well as the mortgage boom. One of the pioneers of online lending, CCR is utilizing its leadership to outperform its peers. In the May quarter, the Internet accounted for 46% of fundings, up from 32% in the year ago period. With S&P's belief that the future of the mortgage business is increasingly online, this movement towards the Internet is key to CCR's ability to maintain and improve its market share, and relatedly, cost leadership in the scale-driven, commodity-like mortgage business.

Notwithstanding its strong position in home lending, however, Countywide seeks to insulate itself, at least partially, from the ebbs and flows of the cyclical mortgage funding business, through diversification of its earnings base. With the help of its origination platform and relationships with consumers, real estate agents, and financial institutions, it increasingly cross-sells other products. These diversifying businesses include personal lines insurance, mortgage reinsurance, B2B insurance, mortgage closing services and mortgage-related capital markets, which combined contributed 32% to CCR's EPS in the May quarter, up from 24% in the year ago period. S&P believes this emphasis on diversification businesses will serve Countrywide well in the next and future downturns of the mortgage cycle.

Furthering their diversification strategy, CCR became a bank holding company with the acquisition of Treasury Bank in May. This acquisition offers CCR the opportunity to both reduce its cost of funding through deposits and FHLB advances, and more importantly engage portfolio lending, whereby they can originate and hold adjustable rate mortgages (ARM), which are more popular in higher interest rate environments.

Fiscal year 2002 (Feb.) should be the strongest on record for Countrywide, as we see a healthy origination market and relatively low interest rates through year-end. Loan production revenue should nearly double, aided by favorable comparisons, particularly in the August and November quarters. We also see a normal yield curve helping CCR, as net interest income should provide a significant boost to profits. Net servicing income should fall about 70% as a result of refinancing induced prepayments. Net premiums, fees and commission should rise about 25%, as Countrywide continues adds to cross-sell. We are projecting FY 2002 EPS at $4.33, representing a 38% gain from FY 2001.

In FY 2003, we see the economy improving and mortgage rates returning to normal levels of about 8%. Faced with difficult comparisons, we are projecting a 15% decline in loan production revenue from 2002's levels, partially offset by strong gains in servicing. An increased ability to keep ARM loans on portfolio should bolster net interest income. Insurance premiums, commission and other fee income, should continue to grow though at a reduced pace (about 20%). With a small increase in operating expenses, we expect only modest EPS growth to $4.43. As this modest 2003 growth projection attests, CCR is still not immune to the mortgage rate cycle. But in time, we see EPS advancing more consistently as CCR builds its non-funding businesses. Our projection is for a normalized growth rate of about 12%.

Although the strong near-term outlook heartens us, we have conservatively chosen FY 2003 as a bulwark for our target price. Even with our estimate for only modest growth in FY 2003, CCR recently trades at only about 10 times that estimate, giving the shares a P/E to growth (PEG) ratio of about 0.83, versus a peer group average of about 1. We have set a target of $52, which would represent about 18% appreciation from recent levels and would result in Countrywide's PEG roughly matching its mortgage finance peers.

A simple price to book ratio analysis also supports our buy recommendation and could, more aggressively, be used to substantiate a higher target. CCR's shares recently traded about 1.5 times their book value. Our $52 price target would render that yield a price to book of about 1.7, still significantly beneath its peers. A valuation of 2 times book value, in line with peers, would imply a price target of $60, which represents over 26% appreciation from current levels. Eisenstein is a savings and loans and consumer finance industry analyst for Standard & Poor's


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